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Executives

Mark Leonard - Chairman and President

Jamal Baksh - CFO

Analyst

Blair Abernethy - Cantor

Scott Penner - TD Securities

Thanos Moschopoulos - BMO Capital Markets

Paul Steep - Scotia Capital

Paul Treiber- RBC Capital Markets

Richard Tse - Cormark Securities

Ralph Garcea - Global Maxfin

Constellation Software, Inc. (OTCPK:CNSWF) Q2 2014 Earnings Conference Call August 1, 2014 9:00 AM ET

Question-and-Answer Session

Operator

Good morning, ladies and gentlemen. Welcome to Constellation Software Inc.’s Q2 2014 Results Conference Call. I will now like to turn the meeting over to Mr. Mark Leonard. Please go ahead, Mr. Leonard.

Mark Leonard

Thank you Valerie. Welcome everyone to the Q2 call. I’ve got Jamal here with me and we are happy to take your questions, Valerie is going to queue those up right now.

Operator

Thank you, Mr. Leonard. We will now take questions from the telephone lines. (Operator Instructions). Our first question is from Blair Abernethy with Cantor. Please go ahead.

Blair Abernethy - Cantor

Mark, just wanted to focus on the TSS business for a second. You made good progress on your margins sequentially. Just want to see how that restructuring is looking as we kind of move into the back half and sort if you have any or what your margin targets are there for the year firstly? And then I guess secondly, would any of the five acquisitions made down in the TSS business or how is that acquisition pipeline looking?

Mark Leonard

Okay, a couple of questions there. One is a point of request for forecast which we don’t give. What we’ve said in the past is that TSS is a business that has a much higher component of professional services activities inside of it. That isn’t going to change anytime soon, although we hope for sure that they will build their recurring revenues overtime. Hence, we tend to believe that they will ultimately have lower margins than our other pure software type plays.

But when we get there and whether we get there is to be seen and regarding acquisitions they have done an acquisition and they have a couple of fulltime folks looking for acquisitions as well as the management team participating in that activity. So we anticipate that like our other businesses they will be serial acquirers of local vertical market software businesses and gradually will branch out from an (avalanche) [ph] to other geographies.

Blair Abernethy - Cantor

Okay, great thank you. And just one other quick question if I could just on the organic growth in the public sector in particular looked strong this quarter up about 7%. Any commentary or color you can us there in terms of how the spending environment is looking at state and local levels.

Mark Leonard

For sure there is the environment issue. But I think what you are seeing here is a deliberate attempt to invest in and cultivate organic growth inside of our businesses. If you track our R&D and sales and marketing spending and look at what’s happening to the headcount in those functions as a proportion of our spending and our headcount it’s been going up and that’s hopefully designed to drive organic growth, whether we get the returns on those investments or not is yet to be seen but I think we are seeing some early signs.

Operator

Thank you. Our next question is from Scott Penner with TD Securities. Please go ahead.

Scott Penner - TD Securities

Just Mark probably top of mind is just any comments you would make on the acquisition environment, right now your own funnel how would you characterize it versus let’s say last quarter.

Mark Leonard

The funnel looks better, but the proof is in the pudding, it’s getting things across the finish line. And we didn’t close that many transactions of good size over the course that lasted a while, they’ve been quite small. Nothing wrong with nice small acquisitions, we would love to do a bunch of them and but one would hope to -- I would have hoped that we would have invested more capital in the first half.

Scott Penner - TD Securities

And when you look at that hope versus the reality, I mean is there any maybe hold up is the wrong word, but is there anything in particular that you would call out as a factor in not getting some of those deals done?

Mark Leonard

I think maybe expectation, Scott. If you look at the market with five into a go, I think people’s expectations are very high and we are signing lots of NDAs getting into conversations with a number of companies but not closing it at the percentage that we have historically.

Scott Penner - TD Securities

And then the margins in the public sector business look like they jumped quarter-over-quarter excluding the TSS. It did look like a higher license mix this quarter, was there anything else that was sort of unusual on your mind?

Mark Leonard

It was a very good license deal signed down in Australia that we announced that I believe helped and then in the public sector in general, the guys are cautious but it seems to be going well.

Scott Penner - TD Securities

Okay, just a couple questions on the standalone TSS financing. Are there any other assets other than TSS in that Constellation Delaware business?

Mark Leonard

Not right now.

Scott Penner - TD Securities

And what is there any -- the filing makes (lose) [ph] to some limitations, the future acquisitions of TSS limited this to some extend to the cash that they themselves generate or can you still funnel capital over there?

Mark Leonard

We can funnel capital over there once we get the minority shareholding agreements signed in. Obviously we’ll have a partner and you have with any partnership to make sure that you work within the constraints of your partner. And so to the extent they -- the partners can or can’t come up with the capital, we’ll have to figure out how we handle larger transactions if we’re going to try and do them through the management team at TSS.

Operator

Thank you. Our next question is from Thanos Moschopoulos with BMO Capital Markets. Please go ahead.

Thanos Moschopoulos - BMO Capital Markets

Mark I am wondering if there is any natural trade-offs between organic growth and M&A. And so in healthy climate your managers perhaps spend a little bit more focus in terms of capitalizing on organic opportunities which slowdowns M&A or the two activities sort of really independent of each other.

Mark Leonard

We’ve talked about this at the Board and would be operating groups and I think there’s definitely a diversion of attention that you see with acquisitions. A number of operating groups are now getting to the stage where some of the smaller acquisitions can happen without the involvement of the general manager of those operating groups. But if it’s anything sizeable, it’s going to suck those guys in. And they are also the ones that tend to make change happen around the organic processes inside the business. It isn’t that they come up with the ideas that will create organic growth. But they create the environment and the processes that foster organic growth. And so they can be doing one or other it’s hard to do both. And so I think there is a natural trade-off, I think that's -- I think we’ve seen it.

Thanos Moschopoulos - BMO Capital Markets

A question for Jamal, taxes were higher this quarter and you explained that that was due to the Australian tax credits. And so to be clear going forward, should we still be looking at 10% to 15% rate or is your guidance changing on that front?

Jamal Baksh

I still think we’re in that range. It definitely is starting to trend up, in terms of the differential between Q1 and Q2 I would say there is truly like about 0.5 to two points that has gone up just because we’ve got business now that are fully taxable in the U.S. and the rates are going up. So I still think they offer limit polls that we’re probably trending closer to upper limit and the lower that we have in the past.

In long-term unless we’re acquiring increasing amounts, I think you’re going to see the tax rate trend upwards.

Thanos Moschopoulos - BMO Capital Markets

And just one last one, in the notes of the financials you didn’t disclose the contribution from the 2014 acquisitions because it wasn’t material. So just curious as to what your threshold for materiality would be?

Mark Leonard

We’re using sort of what the OSC uses, so if it’s 20% of our net income for example on a consolidated aggregated basis. We would consider that material.

Operator

Thank you. Our next question is from Paul Steep with Scotia Capital. Please go ahead.

Paul Steep - Scotia Capital

Mark maybe talk just a little bit about if we drilled down into public for a minute, the transportation grew particularly Trapeze looks like they had a record user conference this year. How should we think about organic growth in that area and you have talked a little bit more about R&D. It looks like they have obviously hired a CTO in that business and the business appears to be ramping. Maybe talk specifically about Trapeze for a minute and the growth prospects there.

Mark Leonard

Sure, so I think the processes I was talking about earlier to foster organic growth. I think there the most advanced of our groups in terms of doing that as they centrally managed activity, so in other works creating a group that takes ideas and (goes) [ph] through them and helps the people who generate those ideas, put elevated pitches around them and determine whether they’re going pursue them or not and then flesh out the ideas and look for sponsors among the user community and things of that nature.

So the whole innovation process at Trapeze I’d say is more advanced. That doesn’t mean that in some of our other individual businesses they don’t bubble up some great ideas and make them happen without a whole lot of process. But I’d say as a repeatable activity Trapeze is definitely ahead of most of the other groups.

And I don’t think that necessarily comes down to a CTO by the way. I think product ideas come from customer intimacy not cutting edge code. And I think the Trapeze guys are trying to be as close to their customers as they can.

Paul Steep - Scotia Capital

Understood. I wasn’t trying to single out one person, I just looking more as this is the prototype for the group and what I was thinking about more was if you look at the size of their user conference, the size and sort of development of this group. Is there a logical investment here where actually maybe even take margins down for a little bit and you build, I know you don’t like cost structure but you build some of that into the core and then try to drop some of those processes back into other groups like Harris and sort of buildup larger companies because Trapeze is clearly a large standalone software company yet in its own right at this point.

Mark Leonard

Yes, all North American transit businesses amongst our largest individual business units and hence kind of forward a level of infrastructure that many of the other business units can’t afford. That’s partially because the addressable market in that particular vertical is quite large. If you take one of our small verticals let’s say the Gallery’s software business, it’s a small addressable market that doesn’t have the same kind of cash to throw around that the transit authorities did and they are managing assets that are much smaller than the transit authorities. So, you never going to see a market size in that particular space that’s comparable but my sense is that they are trying to innovate and using a lot of the same processes that Trapeze uses inside the Gallery’s business to grow their business organically.

And I think you will see the same across many of our smaller verticals as well and so the trick is to scale those processes, so they work in tiny little verticals and very large verticals and we run the gamut from 20% businesses to 400% businesses and we think we understand how to work at both ends of that extreme.

Paul Steep - Scotia Capital

Okay, last one from me is just we touched a little bit on the fact that with TSS you have a partner involved there. How should we think about how are you going to evaluate that process as to whether or not you do, not just that deal but specifically in the future as I am thinking about private equity firms for example may or may not be good partners but there is a large number of vintage deals out there that are likely looking for a new home at this point or refunding. How would you think about partnering with another organization, private equity or other alliance going forward like just sort of two year valuation for the Board to see how this one works out first or would you move before that?

Mark Leonard

Yes, I am hoping both the Board and the shareholders are evaluating it. Free cash flow ultimately will be the determinant of whether this has been a success or not. We paid a lot of money for TSS. We have been able to make that slightly less burdensome by using standalone debt inside the acquisition that cuts both ways. Leverage makes things better when you run the thing well and makes it worse when you run it poorly.

And we anticipate that the things will go well and we hope that inside of couple of years, we will be very happy with the experiment and we will consider others. Finding the right partners in non-trivial and I think anyone whose partner don’t understands that.

Operator

Thank you. The following question is from Paul Treiber from RBC Capital Markets. Please go ahead.

Paul Treiber- RBC Capital Markets

Thanks and good morning. I was just hoping to clarify in terms of your threshold for press releasing acquisitions, have you changed the threshold that you will consider press releasing acquisitions this year versus prior years?

Jamal Baksh

I think it was the beginning of this year we went to 10 million as a size and it used to be 5.

Paul Treiber- RBC Capital Markets

And also I think in July, Trapeze acquired a company called [indiscernible] Holdings in Australia but I didn’t see a disclosure in the MD&A about that deal. Is that because it was below the threshold?

Jamal Baksh

Yes, it would have been part of the group of the acquisition now that we group everything together.

Paul Treiber- RBC Capital Markets

May be just timing on the press release that came out in July but the deal closed in June?

Jamal Baksh

Let me double-check. I'll let you know.

Mark Leonard

Yes, Jamal is looking right now.

Paul Treiber- RBC Capital Markets

Okay, moving on to just on the standalone debt financing for TSS. The interest rate is based on leverage table, what sort of the base case we should be thinking about for the interest on that debt?

Mark Leonard

I don’t have that at my fingertips and what I found historically with these tables is they never work out quite as you think they do. You sort of end up tripping up a step or two on the tables and I tell you what, why don’t we try and get something in the next MD&A about the interest cost in the standalone debt?

Paul Treiber- RBC Capital Markets

And then just lastly, the rights offering you put out a primary perspective. Have you had feedback from your investors on that and what -- if you could just sort of elaborate on your structure around the rights offering?

Mark Leonard

Sure, so we filed the prelim, we are working on the final, we hope to get it done soon. The problem with non-traditional instruments is they are on good precedence and you have to ask about everything to the appropriate authorities. And so it’s been a much slower process than I had hoped. Hoping we will get the final file shortly and vis-à-vis interest, the market will tell us. The rights will trade and there will either be lots of interest or there won't.

Jamal Baksh

And Paul just you know, [indiscernible] closed on June 30.

Paul Treiber- RBC Capital Markets

So it is included in Q2?

Jamal Baksh

Yes.

Operator

Thank you. Our next question is from [indiscernible] Euro pacific Canada . Please go ahead.

Unidentified Analyst

Just a couple of housekeeping questions from me if I could. We’ve heard in the past that 5% year-to-year organic growth is hard to come by without recurring organic growth growing at 7% plus. Has that been the case so far this year and we can get a comment maybe on breaking that down a bit in terms of what’s driving that recurring revenue organic growth?

Mark Leonard

Yes, we give you the breakdown of organic revenue growth once a year in the May timeframe in the presence letter. So if you go back to that, you will see it. It’s a really difficult process to carve up all of the recurring revenue and understand what’s happening inside of it. So we only do it once a year. And since maintenance tends to be a very significant piece of our overall revenues and we try to grow the maintenance component as a percentage of revenues that maybe where the 7% and 5% came from that that you're quoting.

Unidentified Analyst

I see. And just on the TSS side, the restructuring that was being completed this quarter, we’ve heard on the previous call that the restructuring being completed in the last quarter was part of the management initiative there before the acquisition. Is this still the case or is this restructuring part of your initiative at TSS.

Mark Leonard

No, no. It’s their plan and they are executing it. And obviously we are trying to share what we know about vertical market software businesses with them and they are fast learners and I am sure there are nuances of what we think and do that are being incorporated into their plan if they recast it each year. But basically it’s their plan.

Unidentified Analyst

I see. And just one last one from me, really has your experience with the European labor laws and the integration of a PSS over the last few months influence sort of your future plans and are doing business there and can we expect that if there are any larger acquisitions coming to down to the pipe, they will be more North American focused?

Mark Leonard

I don’t think the -- I think it’s something that you build into your models and your investment thesis. And so if there is a higher cost of shifting staff around in Europe, you build that in. So I don’t think it influences whether we would do a large acquisition there.

Operator

Thank you. (Operator Instructions). Our next question is from Richard Tse with Cormark Securities. Please go ahead.

Richard Tse - Cormark Securities

Mark, could you maybe talk about the -- on the opportunity side with respect to acquisitions, what the geographic slit maybe in that pipeline and how that’s different on a year-over-year basis?

Mark Leonard

So on European pipeline -- well, you shouldn’t call it a pipeline, because these are to us what we call suspects. So we contact companies, we start to engage in conversation, hopefully a decade later, we have a transaction. So they are very long players. And in terms of those generation of suspects, we have been doing reasonably well in Europe I’d say it’s somewhere between 20% and 35% depending upon the month are coming out of Europe. We’re certainly active there and believe this opportunity there. I think it’s going to be important to as long term.

Richard Tse - Cormark Securities

And just switching gears a little bit, on the maintenance renewals rates, has there been any change in terms of how that’s trending over the past for a while and what’s the ability like to get the price increases on those maintenance renewals?

Mark Leonard

Those are the things I monitor personally. I’m sure if someone, somewhere inside the organization does but it’s not a real focus. I tend to look at the attrition once a year as we get the stats in. But the way we run is highly decentralized. We’ve got this large number of individual business units with general managers running them and I am hoping that they know which of their clients are thinking about leaving and are following their maintenance renewals and trying to decide if they’ve added enough value, if they can put through price increases things of that nature. So it’s not a central activity Richard, but once a year.

Richard Tse - Cormark Securities

And then just one question. I think you touched on R&D at the beginning of the call. But TSS as a greater proportion in R&D. It sounds like you are just going to let that already but I guess would you sort of consider upping your own R&D? How do you think about R&D in general as you look at that organic growth going forward?

Mark Leonard

Yes. so R&D isn’t a down lever that I have my hand on. It’s one obviously that I monitor, it’s an investment generally in both sustaining R&D and in initiatives things that are aimed at future revenue generation. And it’s the later component that I believe is the toughest part of running a software business. So I am really keen on understanding how our people do that initiative investment and I encourage them to try and do it as rationally as possible. Measurement is the only way you end up doing that well. And so I encourage them to track initiatives and to recognize the fact that some of them aren’t working and to triage them and to try and get customers involved in financing such things as much as possible.

Operator

Thank you. Our next question is from Ralph Garcea with Global Maxfin. Please go ahead.

Ralph Garcea - Global Maxfin

Just following up on the European question I guess for Mark. I mean do you have any preferences on areas where you’re looking and where the better opportunities are evaluation wise between let’s say Nordics, BENELUX, UK from a pipeline perspective.

Mark Leonard

No really not. Those all sound like good places to do business.

Ralph Garcea - Global Maxfin

And they are all rationale in their expectations or?

Mark Leonard

When you are selling the business that you built over 20 years or 30 years you think it’s the prettiest thing out there and hence looking for big prices and there is a process of sort of coming down to reality and sometimes we end up being the winner as the expectations ratchet it down and sometimes we don’t.

Ralph Garcea - Global Maxfin

And then I guess for Jamal. Have you seen any issues on the collection side or from a DSO perspective between the TSS customer base and what you’re historically used to see from a North American perspective?

Jamal Baksh

No, the metrics at TSS are actually pretty stellar from that perspective so we -- from a CSI perspective there has been some deterioration in working capital from a web and inventory perspective. But I would say TSS is causing any working capital decline.

Operator

Thank you. There are no further questions registered at this time. I would like to turn the meeting back over to you Mr. Leonard.

Mark Leonard

Thank you Valarie. Thanks everyone for joining the call, look forward to chatting with you in three months' time. Bye.

Operator

Thank you John and the conference has now ended. Please disconnect your lines at this time. we thank you for your participation.

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